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Multiplier Approach to Share Valuation

In the previous chapter, we used formulas based on dividends. But many companies don't pay dividends! How do we value them? We use Relative Valuation or the Multiplier Approach. Instead of looking at future cash flows, we compare the stock to its peers or its own history.

1. What is the Multiplier Approach?

The multiplier approach (also called Relative Valuation) assumes that similar companies should sell for similar prices relative to their earnings, book value, or sales.

[!TIP] Core Logic: "If Company A is similar to Company B, and Company B is trading at 20 times its profit, then Company A should also be worth roughly 20 times its profit."

2. Key Valuation Multipliers

The most common "multipliers" used by analysts are:

A. P/E Ratio (Price-to-Earnings Ratio)

The most famous multiplier. It tells you how many rupees the market is willing to pay for every ₹1 of profit.

  • Formula: Stock Price / Earnings Per Share (EPS)
  • Usage: A high P/E might mean the stock is overvalued or that investors expect very high growth.

B. P/BV Ratio (Price-to-Book Value)

Compares the market price to the 'accounting value' of its assets.

  • Formula: Stock Price / Book Value Per Share
  • Usage: Commonly used for Banks and Finance companies where assets are mostly cash and loans.

C. Price-to-Sales (P/S) Ratio

Compares the price to the total revenue generated.

  • Formula: Stock Price / Sales Per Share
  • Usage: Useful for new startups that have high sales but haven't made a profit yet.

3. How to Calculate Value using Multipliers

To find the "Estimated Price" (P) of a stock, we multiply the company's financial metric by the Industry Average Multiplier.

Steps:

  1. Find the EPS of the company.
  2. Find the average P/E ratio of similar companies in the same industry.
  3. Price = EPS × Industry P/E

Practical Examples (Exam Style)

Problem 1: Company XYZ has an Earnings Per Share (EPS) of ₹15. The average P/E ratio for the IT sector is 25. What is the estimated share price of Company XYZ using the multiplier approach?

Solution:

  • EPS = ₹15
  • Sector P/E (Multiplier) = 25
  • Estimated Price = 15 × 25 = ₹375

Problem 2: A bank has a Book Value Per Share of ₹200. Similar banks are trading at a P/BV multiplier of 2.2. Calculate the fair value of the bank's share.

Solution:

  • Book Value = ₹200
  • Multiplier = 2.2
  • Fair Value = 200 × 2.2 = ₹440

Comparison: Dividend Model vs. Multiplier Approach

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Exam Pattern Questions and Answers

Question 1: "What is the Price-to-Earnings (P/E) multiplier? Why is it popular?" (6 Marks)

Answer: The P/E Ratio is the ratio of a company's share price to the company's earnings per share. It represents the "multiple" that the market is willing to pay for the company’s current earnings.

Why it is popular:

  1. Simplicity: It is easy to calculate and understand for common investors.
  2. Comparison: It allows for a quick comparison between different companies in the same industry (e.g., comparing TCS P/E with Infosys P/E).
  3. Market Sentiment: It reflects what the overall market thinks about the company's future growth. A high P/E usually indicates high market confidence.
  4. Universality: Almost every public company reports earnings, making this multiplier widely applicable.

Question 2: "Explain the Price-to-Book Value (P/BV) ratio and its significance." (4 Marks)

Answer: The P/BV ratio compares the market price of a stock to its book value (net assets minus liabilities).

  1. Safety Net: It shows how much an investor is paying for the actual physical assets of the firm.
  2. Undervalued Stocks: Value investors often look for stocks with a low P/BV (close to 1), as it may indicate that the stock is trading near its "liquidation value" and is safely priced.
  3. Sector Specific: It is the "Gold Standard" for valuing financial institutions (Banks/NBFCs) where the balance sheet accurately reflects the company's true worth.

Summary

  • Multipliers provide a Relative view of value.
  • P/E is the most widely used multiplier based on profit.
  • P/BV is preferred for asset-heavy industries like banking.
  • Multipliers are best used to compare a company with its Industry Peers.

Quiz Time! 🎯

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